Learn concept of effective hedging

By Sahaj Agrawal, AVP- Derivatives, Kotak Securities

The Indian markets currently are extremely volatile often posing large risk to investors- both retail and institutional alike. As we have understood in previous articles, the constant volatility in today’s market environment usually leads to variations in asset price and the exposure of your holdings to continued financial risk and loss.

We do know that risk is constant and a typical element of capital market investing. Managing this risk and associated uncertainties are extremely important. Hence many investors choose to use Derivative Contracts that help manage these risks effectively. As derivatives have no independent value of their own, they derive values from the assets they represent. Hence, trading in derivatives is also a form of insurance against unexpected price movements, volatility of markets, uncertainties of Company performances.

One of the most common reasons for investors to participate in Derivatives is the availability of hedging alternatives. In simple terms, hedging would mean the reduction of risk. In other words, Hedging means insuring against risk of loss due to unexpected situations and is akin to us investing in insurance for our lives, medical expenses, even our homes, cars or business assets.
An investor who is looking at reducing his risk opts for Contracts that allow him to spread or reduce his risk and exposure to price volatility in Equity Instruments while still being an active participant in the market. In a derivative market, such a trader would usually take up a position that is opposite to the risk he is otherwise exposed to. He thus is insuring and limiting his losses in case of unfavourable movements in the underlying asset.

Before opting for an efficient hedging strategy, it is extremely important to first accurately assess the risk that needs to be covered and have the same evaluated and validated by thorough market research. This would help measure the risk exposure in tangible terms and allow the most optimum strategy to be implemented for hedging. Using Derivatives effectively, you can develop and customize strategies where you insure or offset potential unexpected loss in the equity segment by betting on a potential expected gain on your Contract.

Given the flexibility offered by Derivative Contracts, you as an investor can customise and offset risk against most given situations by combining various permutations and combinations available to you. But as with insurance, hedging also comes at a price. While these may in terms of profits offset by losses or even expenses incurred in order to hedge. Thus, before you consider hedging as an option, it is advisable to accurately estimate the risk you wish to hedge against and the price you would pay. Remember that the cost you will incur in hedging is directly proportionate to the potential risk of the underlying asset or in this case, the stock you hold. Therefore, the higher the risk, the higher the price will be. In some rare cases, you may find yourself in a better position financially, if you had in fact not considered hedging at all.

The risk represented by the asset is usually dependent on volatility and external factors surrounding performance of that asset including time. If the stock can sustain its price efficiently over times, irrespective of external factors, then the risk on the Contract derived from it is fairly low. Thus the cost of hedging such a stock is also fairly low. If however, the stock displays rapid price movements in shorter time spans, then it is considered risky and the cost of hedging it would therefore work out to be fairly expensive.

The way markets are shaping up amidst the current global economic situation, expecting the markets to trade within a broad range would not be wrong. Hence for long term investors to effectively deploy hedging strategies in euphoric times, could actually help reduce the long term holding costs as well as provide a safety net in case the turmoil accelerates. So access risk and hedge effectively to make the most of any situation, especially if it is adverse and remember, all of this comes at a cost.

No pain no gain. Happy Hedging!

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